Beat the Market in Your Spare Time with My Proven Strategy

[Honest subtitle: Ten-year Report on My Experiment in Measured Contrarianism in Personal Finance]

A decade ago this summer, my wife and I returned from nine months in Saigon. We flew back to the States with more cargo than we left with: Mai, a Vietnamese-American, was expecting our first child. (Also packed on the plane were matching T-shirts for mother and son with "Made in Vietnam" embroidered in both English and Vietnamese.) Needless to say, that summer was a time of great change. We moved to a new city, Baltimore. Mai started a new phase in her medical training. We bought our first car, an old Corolla from her brother. We prepared for the baby. According to the division of labor between us, managing the financial consequences of our transitions fell to me. I opened a checking account at a local bank and found renter's insurance for our new place. I bought auto insurance and---another first---life insurance for us both. I also confronted the question of what to do with the small amount of money Mai had accumulated in a retirement fund in her previous job.

Earlier, my father had introduced me to the writings of John Bogle. Creator of the first index mutual fund for individual investors, founder of the Vanguard Group (now the largest mutual fund company in the world, or right up there), and author of several clear and responsible investment books, no one has done more for the ordinary investor. Bogle famously advocates a simple strategy: put all your money in index funds and set your stock-bond split based on your age and general risk tolerance. A rough rule of thumb is that the % of your portfolio in bonds should equal your age, and the rest should be stocks. A minority of your stock portfolio should be overseas. Bogle argues that it is foolish to try to beat the market, so you should just buy the whole market through low-fee index funds, thus ensuring that you are not ripped off by slick brokers and Wall Street types who claim they can beat the market.

This all made sense to me. But I wondered: why does Bogle second-guess the market when it comes to the stock-bond split and the foreign-domestic split? Why not buy a single index fund of all traded securities in the world, each weighted according to their total market value? If the total value of foreign stocks is twice that of domestic ones, then your portfolio would hold these two assets types in the same ratio. Ditto for stocks vs. bonds. Or conversely, if it is wise to second-guess with regard to stocks vs. bonds and foreign vs. domestic, why not go further and second-guess the market more finely? How did Bogle draw the line?

The Internet age had dawned, so I started searching online, and soon uncovered a set of investment ideas you might call "slice and dice." It draws from two historical streams of thought. The first is the tradition of value investing most associated with Warren Buffet and his teacher Benjamin Graham. Value investing emphasizes looking for companies that appear cheap compared their book value or earnings. It is inherently contrarian since it is founded on the premise that the market systematically overestimates the prospects of some companies and underestimates those of others. The other stream is Modern Portfolio Theory, and a particularly influential 1992 paper within it, by economists Eugene Fama and Kenneth French. Using a vast database of U.S. stock prices, they simulated several investment strategies over 1962--89. They found that small-company stocks handily beat large-company stocks and that value stocks (ones that had a low market price compared to the accountants' estimate of their assets on the books) beat the high-priced, so-called "growth" stocks. Both margins averaged about 5%/year. Moreover, if you knew just three things about a stock mutual fund---the shares of small and value stocks in its portfolio, and the share of cash vs. stocks (which could be negative if there was leverage)---you could predict with remarkable accuracy the performance of the fund in any particular year, knowing only how well the overall market had done that year, how much value stocks had beaten (or lagged) growth, and how much small companies had beaten (or lagged) large ones. In other words, there was precious little sign that the skill of mutual fund managers in picking individual stocks had helped them beat the market.

The finding that boring value stocks (like Ford today) had actually beaten sexy growth stocks (think Google now) was particularly puzzling because returns to value stocks had been less volatile over the years. Risk and return were supposed to go hand in hand, but here investors got less risk and more return.

One intriguing part of the academic story---what made the Fama-French paper so significant---is that it seemed to contradict the Efficient-market Hypothesis Fama had put forward in his Ph.D. thesis in the early 1960s. The EMH is the sort of contribution that could earn a Nobel. It says not that stock prices are always correct, but that they always reflect all available information. Thus no one has special insight with which to beat the market. It does counsel a healthy humility. Yet the 1992 paper seems to say that the market has been systematically irrational for decades, in a way that made it easy to beat. Here you can watch Fama struggle to reconcile these two contentions, rather painfully I think. Though I don't follow these matters closely, it appears to me that since 1992 behavioral economists such as Richard Thaler, the same ones who are now helping us understand how to market financial services to the poor for maximum benefit, have gained the upper hand. They have offered several EMH-violating theories to explain why boring value stocks have beaten hyped growth stocks over the long haul. One I learned from Robert Haugen's New Finance says that the market on average correctly sorts stocks by how much their profits will grow---through stock pricing, it exhibits some insight into which companies will do better---but that its expectations overshoot. The market overestimates the prospects of growth stocks while underestimating those of value stocks, just as individuals overestimate their own luck and skill when judging how much debt they can handle. Roughly speaking, the market overprices Google and underprices Ford. Then, on average, the growth stocks have more negative earnings surprises and the value stocks have more positive ones, making growth stock fall and value ones rise.

The Fama and French paper led to the slice-and-dice philosophy of investing, which I absorbed, and which is explained wonderfully here and here. Amend Bogle's advice: second-guess the market with respect to the allocation between small and large companies and value and growth companies. Do this by putting some money in index funds that specialize in small and/or value companies. The ideas particularly appealed to me in the summer of 1999, when the tech stock market was building up to its mighty climax. It's hard to remember how hard it was to perceive then that tech stocks were in a bubble. I wasn't sure enough to bet aggressively against high-priced tech stocks, but was queasy enough to deemphasized them. I decided to implement slice-and-dice as purely as I could. I allocated my stock portfolio 75-25 value-growth, 75-25 small-large, and 67-33 domestic-foreign (which is less domestic than Bogle generally advises). Today, I'm about 70-30 stock-bond. I maintain a benchmark to gauge my performance relative to the market, using single-fund solutions offered by Vanguard that embody Bogle's advice. I even have a database that automatically downloads prices each day and updates performance graphs (see below).

I issued the orders to Vanguard to form the portfolio on August 19, 1999. The ten-year results are just in.

In the first 6 months, I badly lagged the market as tech stocks ran up. My relative fortunes reversed after the bubble popped in March 2000, and for the next 6--7 years I handsomely beat the market. (Meanwhile, studies suggest that most small investors like me didn't even come close to matching the market because they keep chasing past performance, such as by buying tech stocks after they'd gone up.) However, in the last three years, I've barely beaten the market. Here are the results by year for my portfolio and the benchmark, before and after adjusting for inflation, using August 19 to mark the breaks between years:

One of the most interesting numbers is near the bottom right. The "market," proxied by these then these once they were launched, lost 7.1% after inflation over the decade, for a real return of --0.7%/year. Back in November 1999 Buffet cautioned investors that they would be lucky to earn 4% real over the coming 17 years. Looks like even his pessimism was optimistic. You can see I earned a cumulative 45.2% more than inflation, 3.8%/year real, barely achieving Buffet's low bar. Still, I beat the benchmark by 52.3% total, 4.5%/year.

This graph shows cumulative performance over time. The top line shows nominal returns for my portfolio. The next one down shows inflation-adjusted returns. The next two do the same for the market benchmark:

This one shows the portfolio-benchmark difference before and after adjusting for inflation:

Notice how my margin over the benchmark plunged after the financial crisis last fall. This is mostly a mathematical artifact, as my portfolio and the benchmark fell about the same in % terms. What's going on? Consider that if the market falls by 100% today, then even though my portfolio and the benchmark will perform the same, the gap between the two will evaporate. If you are twice as tall as your son and both of you loose half your height, your height difference also halves. A bull market inflates outperformance such as Buffet's and a bear market deflates it. To abstract from this phenomenon, I created a measure I call the return ratio (computed as (100%+portfolio performance)÷(100%+benchmark performance)). It's a purer measure of a benchmark-beating track record:

If I had merely stayed even with the market, the ratio would still be 1.0 today. Does it look like it's leveled off in the last couple of years?

Want to copy my strategy? On a hedge fund fee schedule---2% of your assets each year and 20% of the gains (but 0% of the losses)---I'll happily share my secrets...or you can just download my secret spreadsheet, which shows my allocations. I "rebalance" the portfolio, restoring asset allocations to target %'s, about once a year. You can learn more from a rough presentation I did for coworkers a few years ago.

In fact, carrying out the strategy requires discipline and a mathematical bent. William Bernstein concluded that almost no one can do it:

Having spent nearly a decade writing about investment management for the little guy, I have come to the conclusion that I no longer believe in the basic premise of my public persona---a surreal cross between Harry Markowitz and Johnny Appleseed, as a friend put it.

A decade ago, I really did believe that the average investor could do it himself. After all, the flesh was willing, the vehicles were available, and the math wasn’t that hard.

I was wrong. Having emailed and spoken to thousands of investors over the years, I’ve come to the sad conclusion that only a tiny minority, at most one percent, are capable of pulling it off.

I should connect to microfinance. A few lessons: Measured contrarianism seems warranted in affairs of finance. It is the rare person who manages money the way academics and professionals determine is optimal. For most, financial management is a matter of rules of thumb, rough guesses, and ambient uncertainty about what is best. Behavioral economics really does have a lot to offer in helping us understand how people think about and use money, and about how financial services can be defined and described to maximize appropriate use.

Non-microfinance case in point: single-fund-solution mutual funds, such as Vanguard's Target funds, which track indexes and allocate between stocks and bonds according to your expected retirement age, are an excellent choice for most investors. Combined with the new trend among employers, inspired by behavioral economics, to enroll workers in retirement savings plans by default (forcing them to opt out rather than in), these funds are a socially useful technology for a making a good and important decision easy. Studies suggest that if you contributed steadily to such a fund, you'll easily beat most small investors over the long haul.

Will my portfolio continue to best such funds? Is the value premium eternal? Are market actors doomed to perpetual irrationality, which I can continue to exploit? Or has my outperformance already ceased for good, the value premium having been destroyed by its discovery? Was I just lucky to catch the updraft from the collapse of a historic bubble? I'll be at least as interested as you to find out. Asked what he thought of the French Revolution 200 years on, Zhou Enlai quipped "too soon to tell." As for the Fama and French revolution, it might take me 20 years to tell.